The German long-term savings industry is changing. The market is being shaken up by tax reform, which at the close of last year ended benefits for regular savings plans, skewing the tax system towards retirement saving. At the same time, the defined benefit state pension is being wound-up, putting the emphasis on private pension plans. The lumbering incumbent German life companies, however, still offer only very basic endowment policies and with profits funds with low potential returns. As a result, UK life companies, now equipped with more realistic risk management - the consequence of a shake-up in liability matching caused by past indiscretions - are now taking advantage of the more basic German regulatory model to offer German customers life products with a much greater potential for return.
One of these is Scottish Life International (SLI), an Isle of Man based offshore life and investment business, part of the Royal London Group, the UK's second largest mutual insurer. It is no secret that Royal London acquired SLI almost by accident when it bought SLI's parent company, Scottish Life in 2000. However, it was only in 2003, after Royal London had integrated the main Scottish Life UK life and pensions business, that it took a closer look at the offshore business and assessed its potential.
"In 2003, Royal London began to understand what kind of business it owned, in much more depth than it did at the time of the takeover," says David Kneeshaw who was appointed chief executive of SLI in late 2003. The Royal London board decided it was an interesting business to own, but needed a fresh start and a more focused direction. Kneeshaw was given a brief to decide what that direction should be and he reported back to the board in the summer of 2004. "There were a number of things the company did for British intermediaries that could be replicated in other countries. Especially other countries where there is a professional middle class who want financial services products and, traditionally, have had more restricted access to them. This means the competitive nature of distribution is lower and margins can be greater," he says.
Alongside the UK business - which is a traditional offshore operation selling its own particular style of capital protected life bonds to high net worth individuals - SLI also had a presence in South Africa, the Middle East, specifically Lebanon and Dubai and, of course, Germany. Business was slow and there had been calls to change the approach, the products being offered and the markets where it was operating. Kneeshaw, however, saw that the decisions that had been made before his arrival weren't necessarily bad, but they required commitment from the company. "You sometimes have to be quite dull," he says, explaining that as an unknown firm, you have to give brokers and customers time to get to know and trust you.
This is what the company has done in Germany, a country it originally entered late in 2002. Recognising a shift in the way Germans would be saving, the company, which operates under the Royal London brand in Germany, offers both Royal London's with profits fund as well as a more complex capital protected, open ended investment called Safe Combination. "In Britain, there has been this move towards transparency. But this is so difficult for with profits; how do you explain smoothing, or discretion? You can't use black and white language with it, and so it has become a difficult product to promote in the UK. It's really sad because it does a perfectly good, long term job of making savings grow," Kneeshaw says.
In the UK, with profits funds received particularly bad press in the early years of the century as equity markets tumbled and bonuses were cut. Kneeshaw points to the particular problem that you couldn't mathematically explain the performance problems in the same way a unit trust could. "German investors, however, understand that with profits funds suffered because the markets went down and are in love with the concept."
Although many German firms are keen to cash in on the expected boom in long term savings, created as a result of pension reform and changes to the tax code, it is UK-based companies that are managing to make real headway into the mass affluent and high-net-worth segments of the populace. Kneeshaw says SLI's main competition comes from Standard Life and Clerical Medical, both of which have been operating in the country for a number of years now.
This comes partly from British expertise with the more complex end of the investment spectrum. "German products tend to be standard endowment policies which will hopefully pay-out more than a cash account. But it isn't going to frighten the horses in terms of investment performance because of the underlying guarantees," says Richard Jamieson, head of marketing at Edinburgh-based SLI. Those people who were burnt by riskier investments during the tech crash are now returning tentatively to the market. "They find themselves in a situation where they are going back, but the German model doesn't really fulfil their needs anymore because payouts have been that much lower," he says. "What UK-based life assurance offers is a less restricted version of that model where the equity investment component isn't restricted in the way it is in Germany." And this is a legacy of the two markets' regulators; one which pushed firms in its jurisdiction to move to realistic capital and solvency levels; and the other which has maintained a book value model of appraisal which has left consumers in the high net worth bracket lacking the products they desire.
The main difference is a restriction imposed by BaFin, the German financial market regulator, on Germany-based life companies, which states that the level of equities in a with profits fund cannot exceed 35%; and, in general, equity levels are much lower even than that. German life companies also still offer guaranteed growth rates, which are restricted to a maximum of 2.75% by BaFin, a level they subsequently offer. Subject to realistic solvency requirements prescribed by the Financial Services Authority, UK life companies now find the capital requirements on such guarantees prohibitive. By avoiding guarantees, firms such as Standard Life and SLI exploit the advantage of investment flexibility. This allows them to offer German high net worth, or affluent individuals, a more exciting product, taking them out of competition with the large incumbent German players such as Allianz or R+V, who are mainly dealing with direct sales to less financially aware customers.
Looking at the asset mix of the Royal London with profits fund over the past five years, it's easy to see that its investment policy is markedly more aggressive. Equity assets as a percentage of the portfolio were 42% in 2004 (falling from a high of 64% in 2001) and the equity backing ratio was 55.5%. Compare this to, for instance, R+V, a large German life insurer with 16.9 million policies, which currently only has 12% of its assets in equities (see Life and Pensions August/September, 2005 p32). However, it is important to note here that German funds offer guarantees, such as terminal bonus guarantees or early surrender guarantees, whereas Royal London's business is unitised and therefore has lower guarantees.
Another factor is the way consumer regulation in the UK and Germany has moulded product offerings, says Kneeshaw. Until recently, British regulation has tended to focus on sales tactics. Product manufacturers could essentially make the products they wanted with regulation focused more on distribution, creating an environment very conducive to product innovation. In Germany, however, regulation has been much more focused on the actual product. The regulator defined the product and the margins, restricting product manufacturers to a pre-defined range. "As a result, at the retail level, it's still quite a simplistic market," he says.
With low product sophistication from indigenous firms, there is a gap that can be exploited by foreign firms that already have a competitive, well developed product range. So far this year, SLI's sales in Germany have been around £40.5 million - a significant proportion of total sales for the year to date of £104.2 million - evenly split between the with profits fund and its safe combination bond; a complex open-ended life bond which allows investors varying levels of capital protection with payout profiles linked to various global stock market indexes. Jamieson expects with profits to finish the year ahead due to a rallying stock market and the greater ease with which it can be explained to the customer.
It hasn't been plain sailing, however. Selling in Germany is not the same as in the UK and the company had to adjust its initial marketing strategy. Kneeshaw says they were concentrating too much on dealing with the head office of its master distribution partners, of which there are six. "Just because head office tells you that a product is good, doesn't mean a local advisor is going to sell it," he says. As a result, the company has spent the last 18 months getting in amongst the individual brokers themselves and educating them about the different products. This patient strategy is finally paying dividends as volumes are beginning to grow: SLI made its Royal London annual sales targets for Germany by June this year and momentum hasn't stopped.
Outside of Germany, the company has made big progress in the Middle East, selling more traditional life insurance products in the United Arab Emirates - specifically Dubai - and Lebanon. Kneeshaw says the firm is targeting an emerging middle class that is developing as stability in the region grows, but which is coming from different demographics than before. In Dubai, whereas before the typical customer was a European ex-pat putting their money into an offshore fund for retirement, the emergent middle class now is from Asia. There are around 600,000 Indians in Dubai alone, he says, many of them are white collar management grade earning good money. "They don't want to send the money back to India and the idea of a British-based or Isle of Man-based company is reassuring. They especially like the Isle of Man protection scheme, which is hugely popular in Dubai," he says. The Isle's consumer protection scheme is, in fact, better than the UK's own compensation scheme.
In Lebanon, Kneeshaw says the fact that the country has a long history of being a sophisticated trading nation has meant there is a growing number of people who have a latent demand for financial services: "The reason we can do good levels of business there is because there are professional, middle class people who earn monthly salaries that go into bank accounts, pay mortgages, pay school fees and so on. These people want to save, and they want life assurance." Another reason is that immediately after the civil war ended, Lebanon set out to create a modern financial structure with sophisticated regulation, which is now in place. Dubai is in the process of doing something similar and Kneeshaw wants to be at the front of the queue when it starts handing out insurance licences.
The company also runs a white labelled business in South Africa, in conjunction with a couple of local partners, selling offshore life bonds. Although this is relatively small at the moment, in September, it signed a deal with Harvest Life, a local life company that should enable it to increase its presence. The reason for using local life companies is that it would be too complex to apply for its own licence and the margins available from a white labelled operation are still attractive. "Margins are slightly smaller, but you have to do less work. The distributor will bring in bulk business and you have lower marketing and distribution costs. It's just selling a capability; in some countries we're the front end, such as Britain or Germany, and in some we're the back. It really doesn't matter," he says.
The company has a very simple strategy when it comes to actually creating its products. All of its capital protected funds are single premium and hedged up front using zero coupon bonds and options. It does delve into slightly less vanilla options as well, using call spreads for its bonus funds, and digital options for its UK deposit bonus funds. Although using Constant Proportion Portfolio Insurance (CPPI) as a way of guaranteeing capital has been immensely popular recently, Jamieson says the company has made a conscious decision not to use it, believing the exposure to the fund cashing out would be too great. The only risk that does enter the books is a wealth insurance policy that investors can put over their entire portfolio in the event of their death, which is hedged in the reinsurance market.
This strategy of halting wanton expansion and concentrating on the markets where it had a presence already, has paid off. Sales targets have been met everywhere except South Africa - although September's Harvest Life deal should boost earnings there - and Kneeshaw's business plans for next year have already been approved by the Royal London board. He has three key projects to work on: obtaining a licence to operate under Dubai's new regulatory regime once it is in operation - something Kneeshaw sees as important enough to take it on personally; the development of a regular savings product; and undertaking a complete IT review.
Regular savings is something Kneeshaw believes will help the company grow much more quickly abroad. Although a review will determine which markets to launch in and what product is best suited to those markets, the company expects to be focusing on Germany and the Middle East. "In the German market there is a large potential for regular savings due to the change in demographics and the move away from a state security net and on to private pension plans," says Jamieson.
With this year's sales targets met, and exceeded, and a solid plan for next year in place, he is bullish about the company's future prospects. "We are extremely profitable this year. Even without regular savings, which wouldn't come on stream until the end of next year anyway, we are aiming for a significant profit hike in 2006," he says.
So bullish, the firm is even toying with the idea of expanding distribution into another European or Middle Eastern country, although he is remaining tight lipped on where for the moment.